We need to go back to the basics of a DCF valuation to understand how inflation factors into the calculation, and why this means using nominal cash flows instead of inflation-adjusted real cash flow estimates.

It’s a minor detail, but could tip the scales on every valuation you ever do.

A DCF, or Discounted Cash Flow, model is a formula to estimate the value of future free cash flows discounted at a certain cost of capital to account for risk, inflation, and opportunity cost.

The riskier the investment, the higher you discount the cash flows.

The more that there are better alternatives for investment (opportunity cost), the higher you discount the cash flows. (This is why discount rates are so low today, since risk-free returns and the returns on strong corporate bonds are painfully low).

And finally, the more that you expect inflation—or to put it another way, the more that you expect that future free cash will be less valuable than today—the more you discount the cash flows.

Why?

Because if cash flows are worth significantly worth more today than in the future, then you have significantly more spending power today than in the future, and so you’ll need higher returns in the future to maintain a similar spending power for those future cash flows.

However you don’t factor inflation into a discount rate, but instead take care of it organically as part of a DCF.

Let me explain.

And let’s go back to the basics of inflation.

**Real Cash Flow vs Nominal Cash Flow**

There are two key terms to remember with inflation: you have **nominal** and **real**. So you have nominal cash flows, and real cash flows, nominal (GDP) growth and real (GDP) growth, and nominal returns and real returns.

- Nominal refers to non-inflation adjusted figures.
- Real refers to inflation adjusted figures.

The misunderstanding of this small distinction runs rampant in economics, and even among talented and smart analysts—which causes inaccurate assumptions.

For example, when economists mention a country having negative interest rates, they don’t mean that an account holder literally has to pay a bank to hold its deposits.

What these economists mean when they quote a country with negative interest rates is that the country has negative **real** interest rates, meaning inflation adjusted, meaning that an account holder actually does receive interest on his/her deposits but actually loses purchasing power due to inflation.

You see this misunderstanding with stock market returns also.

Some people quote the market as having an average of 7% annual returns, while some quote the market as having an average of 10% annual returns.

Both are correct, but the key is in nominal vs real.

The stock market has had 7% **real** returns, while it has also had 10% **nominal** returns—as inflation has averaged around 2-3% a year.

Finally, there’s a key difference in using a DCF on a real vs nominal basis.

Most DCFs are calculated on nominal cash flows.

To quote one of the greatest teachers on valuation, Professor Aswath Damodaran from NYU Stern:

“Nominal versus Real: If your cash flows are computed without incorporating inflation expectations, they are real cash flows and have to be discounted at a real discount rate. If your cash flows incorporate an expected inflation rate, your discount rate has to incorporate the same expected inflation rate.”

So we have to keep in mind that the discount rate we choose to use, whether it’s a real rate or nominal rate, sets the tone for the rest of the DCF model.

That includes the growth rate projection for the free cash flows, and the GDP component if you’re using one (which is often used for terminal value).

That begs the question…

Are most discount rates nominal or real?

**Real Discount Rate Vs Nominal Discount Rate**

Many analysts use the WACC, or Weighted Average Cost of Capital, as their discount rate. This involves using a risk-free rate, and beta, and the cost of debt.

Let’s think about if each of these components are nominal or real.

Note that if you look up the **real** yield for the 10 year and 30 year treasury for 2020, it has been negative since March.

In most of the economic reporting I’ve seen, they’ve been reporting the 10y and 30y at below 1 since the same time period, which is the **nominal** rate.

So our risk-free rate is nominal.

The cost of debt is also nominal.

When these public corporations issue bonds and pay their coupons, they are not paying inflation adjusted coupons. Those are nominal cash flows. Now, inflation (and inflation expectations) may affect the coupon rate, which is generally determined by the market.

But that actual coupon is not inflation adjusted, it is nominal.

Finally, stock prices and free cash flows are also nominal. We don’t see stock tickers adjusted for inflation (though sometimes reported returns are), and companies themselves don’t adjust their earnings or free cash flows to the value of the dollar against purchasing power.

That means that most WACC calculations are nominal, which means most DCF valuation models should also be nominal.

Which brings me to the terminal value.

**Real Terminal Value vs Nominal Terminal Value**

Terminal value is the expected rate of growth for a company in stable state. This tends to follow its economy.

So for U.S. corporations, it’s widely expected to use GDP growth as a proxy for the growth of the economy, which—you guessed it—also has nominal and real values.

I’ll cut to the chase.

U.S. nominal GDP has averaged 4.5% per year from 1994-2019. Over the same time period, U.S. real GDP has averaged closer to 2.5%.

That means if you’re using real GDP (2.5%) in your terminal value, you’re likely undershooting every valuation model you’re doing, if you’re using a nominal WACC (I don’t know anyone who isn’t).

This is why learning valuation the right way is so important.

If you’ve been taking lessons on valuation, you’re likely nodding your head when I talk about the possible inflation components of the WACC, and terminal value, etc.

But if you’ve been skimming this stuff your whole life, you might be lost on what I’m saying.

And so if you haven’t taken the hard effort to buckle down on this valuation stuff, you’re likely missing out on other very **significant** details in your valuations, which will follow **every** valuation through the rest of your investing life.

I don’t think there’s many analysts who think about inflation for valuation.

I certainly didn’t for a long time.

That’s not the point. The point is that a deeper understanding of valuation is crucial to getting good results in the stock market, and that only comes by absorbing the lessons and applying them consistently.